Fitch Affirms Hillenbrand, Inc.; Outlook Stable
KEY RATING DRIVERS
The ratings reflect the cyclicality and long-term growth potential within HI's Process Equipment Group, as well as the healthy margins and cash flow from the company's mature Batesville segment. The ratings further reflect the current weakness in HI's business and its elevated financial leverage following two acquisitions completed in the first half of fiscal 2016 (ending Sept. 30).
The process equipment group (PEG), which accounted for 62% of revenues and 52% of EBITDA in fiscal 2015, experienced a 9.4% revenue decline in the first nine months of fiscal 2016, following a 7.6% decline in fiscal 2015 due to lower demand for equipment used in the plastics, energy and mining markets, and unfavorable foreign currency movements offset in part by the impact of acquisitions. The segment operating margin narrowed to 10.9% (before restructuring and unusual charges) in the first nine months of fiscal 2016 compared with 11.9% in the prior year period.
The Batesville segment which accounted for 38% of revenues and 48% of EBITDA in fiscal 2015, experienced a 5.5% revenue decline in the first nine months of fiscal 2016 due to a decrease in North American burials, following a 2% increase in fiscal 2015. The segment operating margin improved to 23.7% in the first nine months of fiscal 2016 from 22.3% in the prior year period.
On a consolidated basis, Fitch expects HI will generate a low-single digit revenue decline and moderately lower EBITDA margins in fiscal 2016, and that the business will begin to stabilize during fiscal 2017. Fitch expects FCF will improve to a level at or above $100 million in fiscal 2016, helped by a positive swing in working capital, and be sustained at that level in fiscal 2017 with capex estimated at a modest 1.5% - 2.0% of revenues and slightly increasing dividends. FCF will be used for debt reduction over the near term, acquisitions, and a modest level of share repurchases longer term.
HI completed two acquisitions in the first half of fiscal 2016. The acquisition of ABEL Pump, a leader in positive displacement pumps, provides an entry for HI into the flow control industry, while the acquisition of Red Valve, which produces specialized valves and other flow control solutions for water, waste water and industrial flow processes, furthers HI's penetration into the flow control industry. In total, HI paid $237 million for these companies, and financed the acquisitions by drawing on its credit facility.
On a pro forma basis, the acquisitions pushed debt/EBITDA to 2.5x from 1.8x at the end of fiscal 2015. HI has repaid acquisition debt with FCF during fiscal 2016, causing leverage to improve to 2.3x at June 30, 2016. Fitch believes that HI could maintain a faster pace of acquisitions going forward, causing mid-cycle leverage to remain in the low-2.0x range. This leaves less headroom in the rating for operating shortfalls or larger acquisitions. However, Fitch anticipates an increase in leverage above the expected mid-cycle range would be reduced relatively quickly as HI has shown the willingness and ability to pay down debt following leveraging transactions.
As of Sept. 30, 2015, HI's U. S. pension plans were 58% funded, creating an ongoing funding obligation. Contributions to the U. S. and international plans were $20.6 million and $15.7 million in fiscal 2014 and 2015, respectively, and the company expects to contribute $14.9 million to the plans in fiscal 2016.
The ratings incorporate HI's financial flexibility, consistently positive free cash flow (FCF), conservative financial strategy, and broad customer and geographic base. Significant aftermarket revenue in the Process Equipment Group (PEG) generates attractive margins and mitigates the segment's cyclical end-markets and exposure to long-term projects. The Batesville segment provides additional stability, generating consistently strong EBITDA margins of around 25% and a substantial part of Hillenbrand's free cash flow (FCF).
Rating concerns include the potential for increased leverage and execution risk related to acquisitions, cyclical end-markets, operating risks associated with diversifying into adjacent product markets and geographies, and declining industry trends at Batesville. HI's acquisition strategy contributes to opportunities for operating synergies, but PEG's short operating history creates some uncertainty about its performance through economic cycles.
Fitch's key assumptions within the rating case for Hillenbrand include the following:
Revenues decline by around 3% in fiscal 2016, as a high single digit organic sales decline is offset in part by recent acquisitions, before flattening out in fiscal 2017. Longer-term, revenues grow at around 3% annually supported by mid-single digit growth at PEG and 1% annual sales declines at Batesville.
EBITDA margins narrow by 50bps in fiscal 2016 due to lower margins at PEG offset in part by improvement at Batesville. Margins improve gradually thereafter.
Capital intensity remains in line at 1.5% - 2.0% of revenues.
Dividends grow slowly and share repurchases are kept at modest levels, used to offset stock option dilution.
Debt/EBITDA is projected at 2.3x at FYE 2016, and in the low-2x range thereafter.
Negative: Future developments that may, individually or collectively, lead to a negative rating action include:
--Leverage (gross debt/EBITDA) moving above 2.25x on average over time; post-acquisition leverage may increase to 2.5x -2.75x with the expectation that short term debt repayment would get leverage back down to below the average.
--FCF margin below 4% - 6%;
--A sustained decline in the EBITDA margin to below 15%;
--Deterioration in Batesville's revenue and cash flow.
Positive: An upgrade of the issuer's ratings is unlikely in the near term given the risks associated with the acquisition growth strategy and cyclicality at PEG.
Liquidity was adequate at June 30, 2016 and included $47.6 million of cash and cash equivalents (of which $36.8 million was overseas) plus $345.1 million in borrowing capacity under Hillenbrand's $700 million revolving credit facility that matures in December 2019. Revolver availability is constrained by the 3.5x leverage covenant. The next maturities are the term loan and revolver, which mature in December 2019.
FULL LIST OF RATING ACTIONS
Fitch affirms the ratings on Hillenbrand, Inc. as follows:
--IDR at 'BBB-';
--Senior unsecured revolving credit facility at 'BBB-';
--Senior unsecured term loan at 'BBB-';
--Senior unsecured notes at 'BBB-'.
The Rating Outlook is Stable.